New think­ing on non-per­form­ing loans, banks and mort­gages

In a new book which is bound to cause con­tro­versy, two young aca­demics Mian and Sufi (Prince­ton and Chicago univer­si­ties, re­spec­tively) pro­vide new think­ing and ideas on loans and mort­gages. Should banks share the cost of non­per­form­ing loans? Are aus­ter­ity poli­cies on credit lead­ing us in the wrong di­rec­tion? What brought about the cur­rent re­ces­sion?

Con­trary to much popular belief, the bank­ruptcy of Lehman Bros was not the main fac­tor be­hind the 2008 re­ces­sion which swept the USA and much of the rest of the world. In an anal­y­sis which may have ma­jor im­pli­ca­tions for Cyprus, the au­thors iden­tify hous­ing debt and losses as­so­ci­ated with the col­lapse of house prices as a much more likely trig­ger for the cur­rent re­ces­sion.

In the ma­te­rial be­low I only fo­cus on the main points of the book (“Atif Mian and Amir Sufi - Univer­sity of Chicago Press, 2014) re­gard­ing banks and mort­gages. Th­ese fall un­der two main themes:

1. The prob­lem

The present laws re­lat­ing to bank credit for hous­ing are mis­guided. The present sys­tem does not only carry much of the re­spon­si­bil­ity for the present eco­nomic down­turn, it is also un­fair to the home­owner. Un­der the cur­rent sys­tem a down turn in house prices may mean that home­own­ers, hav­ing paid their mort­gage for years, may lose all of the eq­uity in their home, as many have done. Some home own­ers may find that they have not only lost their eq­uity but they now owe the bank more than the home is worth.

This is un­fair to the bor­rower as well as coun­ter­pro­duc­tive for the broader econ­omy. As the au­thors point out: banks choose their debtors. They have de­vel­oped sys­tems for do­ing this. If they have made a mis­take, why should the re­spon­si­bil­ity for this fall en­tirely on the bor­rower? It would be fairer and eco­nom­i­cally more con­struc­tive if losses and gains due to changes in house prices were shared.

2. Pro­posed so­lu­tion

The au­thors ad­vo­cate “shared re­spon­si­bil­ity mort­gages” (SRMs). Th­ese have a re­sem­blance to eq­uity. They are “eq­uity like” and act as a counter to the sort of hous­ing re­lated business cy­cle we have been ex­pe­ri­enc­ing. On the down part of the cy­cle, losses due to changes in house prices are shared with the bank.

The pro­posed SRM is con­nected to a house price in­dex. If the price of a house (ac­cord­ing to the in­dex) falls be­low the pur­chase price, the pre­vi­ously agreed mort­gage in­ter­est pay­ment would also drop. The pay­ment sched­ule re­mains the same but the amount due is now less (the mort­gage in­ter­est pay­ment re­duc­ing in pro­por­tion to the drop in house prices). If the owner keeps the house un­til the full term of the mort­gage, he/she would have paid less than the ini­tially agreed mort­gage.

If the drop in house prices per­sists, the owner of the house would also suf­fer a drop in the eq­uity held in the value of the house. But, un­like the present scheme, the owner would still re­tain some eq­uity in the house, the amount de­pend­ing on the size of the drop in the house price in­dex.

If, after hav­ing fallen, the price in­dex rises, the sys­tem goes into re­verse and the home own­ers’ mort­gage pay­ments would rise in line with the in­dex.

COM­PEN­SAT­ING THE BANKS

Un­der this sys­tem the lenders (banks) in­cur greater risk, for which they should be com­pen­sated. There are two pos­si­ble ways to pro­vide this ex­tra com­pen­sa­tion.

(a) The au­thors es­ti­mate that (based on USA data) the lender could be com­pen­sated by an ad­di­tional charge equal to “1.4% of the ini­tial mort­gage amount”, or,

(b) This ex­tra charge could be elim­i­nated by an agree­ment giv­ing the lender a small share in the up­side of any cap­i­tal gain when the seller re­fi­nances or sells the house. This is es­ti­mated (us­ing data on USA his­tor­i­cal house prices) at 5% of any cap­i­tal gain.

The above is only a briefest out­line of some of the book’s main points. They are clearly con­tro­ver­sial as well as timely and in­no­va­tive.